BULGARIAN NATIONAL BANK

The Currency Board in Bulgaria:

The First Two Years
DISCUSSION PAPERS

Jeff rey B. Miller

1/1999
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October 1999
 DISCUSSIon PAPERS
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Editorial Board:
Chairman: Garabed Minassian
Members: Roumen Avramov
Georgi Petrov
Secretary: Lyudmila Dimova

© Bulgarian National Bank, October 1999

ISBN 954 ≠ 9791 ≠ 28 ≠ 9

Received August 1999; accepted September 1999.

Printed in BNB Printing Center

Views expressed in materials are those of the authors and do not necessarily
reflect Bank policy.

Send your comments and opinions to:

Publications Division
Bulgarian National Bank
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E-mail: dimova.l@bnbank.org

Web.site: www.bnb.bg

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 Discussion Papers
Contents

I. The Structure of the Currency Board in Bulgaria ..................... 6

II. Advantages of a Currency Board ................................................. 9
Convertibility ..................................................................................... 9
Macroeconomic Discipline ............................................................ 11
Guaranteed Adjustment Mechanism ............................................. 13
Confidence in the Monetary System and Promotion of Trade,
Investment and Growth .................................................................. 14
III. Disadvantages of a Currency Board ..........................................15
Transition Problem ......................................................................... 15
Adjustment Problem ....................................................................... 17
Crisis Problem ................................................................................. 19
Political Problem ............................................................................ 20
IV. Conclusions ..................................................................................20
Bibliography ........................................................................................ 27

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 Discussion Papers
SUMMARY: BULGARIA EXPERIENCED A SEVERE FINANCIAL CRISIS IN 1996 AND EARLY
1997. SEVERAL BANKS WERE CLOSED, INFLATION REACHED HYPERINFLATIONARY LEVELS AND
OUTPUT DECLINED SHARPLY. DURING THIS PERIOD PROPOSALS WERE PUT FORWARD TO ESTAB-
LISH A CURRENCY BOARD. IT WAS HOPED THAT A CURRENCY BOARD WOULD RESTORE CONFI-
DENCE AND HELP STABILIZE THE ECONOMY.
T HE CURRENCY BOARD WAS ESTABLISHED IN JULY 1997. IN MANY RESPECTS THE CUR-
RENCY BOARD HAS BEEN A GREAT SUCCESS. FROM HYPERINFLATIONARY LEVELS IN FEBRUARY
1997, INFLATION FELL TO VERY LOW LEVELS IN 1998 AND EARLY 1999. T HE DRAMATIC FALL
IN NOMINAL INTEREST RATES MADE IT POSSIBLE FOR THE GOVERNMENT TO REDUCE LARGE
GOVERNMENT DEFICITS. THE ECONOMY HAS ALSO BEGUN TO GROW, ALBEIT MORE SLOWLY
THAN MIGHT BE HOPED DURING A RECOVERY PERIOD.
A CURRENCY BOARD ESTABLISHES A FIXED EXCHANGE RATE AND RELIES ON AUTOMATIC
MECHANISMS TO RESTORE MACROECONOMIC EQUILIBRIUM. IN THEORY, LIKE THE GOLD STAN-
DARD, THE MONEY SUPPLY WILL AUTOMATICALLY ADJUST WHEN BALANCE OF PAYMENTS DIS-
EQUILIBRIA ARISE. A CURRENCY BOARD RESTORES CONFIDENCE BY RELYING ON THESE AUTO-
MATIC MECHANISMS AND SEVERELY LIMITING THE DISCRETION OF POLICYMAKERS.
W HAT DISTINGUISHES CURRENCY BOARDS FROM OTHER FIXED EXCHANGE RATE REGIMES
IS THE CREDIBILITY OF THE EXCHANGE RATE FIX. CONFIDENCE IN THE CURRENCY IS MAIN-
TAINED BY PROMISING NEVER TO CHANGE THE EXCHANGE RATE AND ALLOWING THE PUBLIC
TO OPENLY EXCHANGE AS MUCH LOCAL CURRENCY FOR RESERVE CURRENCY AS THEY WISH.
THE CREDIBILITY OF A CURRENCY BOARD DEPENDS ON BOTH ECONOMIC AND POLITICAL FAC-
TORS. TO SUSTAIN CONFIDENCE, THE CURRENCY BOARD MUST HAVE SUFFICIENT FOREIGN CUR-
RENCY RESERVES TO HONOR THE PLEDGE TO EXCHANGE LOCAL CURRENCY FOR RESERVE CUR-
RENCY. POLITICALLY, THE GOVERNMENT MUST BE PREPARED TO MAINTAIN THE FIXED EX-
CHANGE RATE WHEN ADVERSE CIRCUMSTANCES ARISE. TO BUILD CONFIDENCE IN THE CUR-
RENCY BOARD AND MAKE IT DIFFICULT TO CHANGE THE EXCHANGE RATE, THE EXCHANGE
RATE WAS WRITTEN INTO THE LAW ESTABLISHING THE BULGARIAN CURRENCY BOARD.
WHETHER THERE IS THE POLITICAL WILL TO SUSTAIN THE BOARD WILL NOT REALLY BE
KNOWN, HOWEVER, UNTIL THERE IS A REAL TEST. THUS FAR THE BULGARIAN CURRENCY
BOARD HAS NOT BEEN CONFRONTED WITH A REAL CHALLENGE , BUT GROWING CURRENT AC-
COUNT IMBALANCES, WHICH ARE LIKELY TO BECOME WORSE BECAUSE OF THE WAR IN
KOSOVO, MAY CREATE PROBLEMS IN THE NEAR FUTURE.
W HILE THE CURRENCY BOARD IN BULGARIA HAS BEEN ENORMOUSLY SUCCESSFUL IN
BRINGING DOWN INFLATION, IT HAS ONLY BEEN IN PLACE FOR ONLY TWO YEARS. IN THIS PA-
PER WE TAKE A LONGER-TERM PERSPECTIVE AND ASSESS NOT ONLY THE BOARD’ S IMMEDIATE
IMPACT, BUT ALSO ITS PROSPECTS FOR THE FUTURE. TWO ISSUES ARE OF SPECIAL CONCERN .
THE FIRST IS BULGARIA’S LARGE FOREIGN DEBT. BULGARIA HAS BEEN ABLE TO SERVICE THIS
DEBT SINCE THE CRISIS ENDED IN 1997, BUT THERE IS NOW GREATER DEPENDENCE ON INTER-

Jeffrey B. Miller, University of Delaware, Newark, Delaware 19716 USA, E-mail:

Millerj@be.udel.edu.
The paper benefited from discussions with Nikolay Nenovsky, Kalin Hrsitov, Boris,
Petrov, Lubomir Christov and Kenneth Koford. Any errors in the paper are the author’s
responsibility. This paper was prepared for presentation at the conference on Banking Re-
form in South East European Transitional Economies, Sofia, 23 – 26 June 1999.

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NATIONAL FINANCIAL INSTITUTIONS. THE SECOND CONCERN IS WHETHER THE AUTOMATIC AD -
JUSTMENT MECHANISMS THAT MAINTAIN BALANCE OF PAYMENTS EQUILIBRIUM UNDER A CUR -
RENCY BOARD ARRANGEMENT WILL BE EFFECTIVE. WITHOUT PROPER ADJUSTMENTS, IT WILL
NOT BE POSSIBLE TO SUSTAIN THE CURRENCY BOARD IN THE LONG RUN.
ANALYSIS OF THESE AND OTHER QUESTIONS RAISED BY THE BULGARIAN EXPERIENCE RE-
QUIRES A MORE DETAILED EXAMINATION OF THE ADVANTAGES AND DISADVANTAGES OF CUR -
RENCY BOARDS. W ILLIAMSON (1995) HAS PROVIDED A FRAMEWORK FOR ANALYZING THESE
ISSUES. IN THE NEXT SECTION WE DESCRIBE THE BASIC STRUCTURE OF THE CURRENCY BOARD
IN BULGARIA. IN SECTION II WE ANALYZE WHETHER FEATURES THAT WILLIAMSON HAS IDEN -
TIFIED AS ADVANTAGES OF A CURRENCY BOARD HAVE INDEED BROUGHT ABOUT THE IMPROVE-
MENTS THAT WOULD BE ANTICIPATED. IN SECTION III WE EXAMINE FEATURES OF CURRENCY
BOARD ARRANGEMENTS WHICH WILLIAMSON CONSIDERS TO BE DISADVANTAGES TO DETER-
MINE WHETHER THEY ARE LIKELY TO CAUSE SERIOUS FUTURE PROBLEMS FOR THE BULGARIAN
ECONOMY. SECTION IV CONCLUDES.

I. The Structure of the Currency Board in Bulgaria

“A currency board is at bottom an arrangement that legislates a par-
ticular monetary rule: a rule that changes in the monetary base will be
equal to the country’s overall balance of payments surplus or deficit.”
(Williamson, 1995, p. 1). A currency board differs from a central bank
in that all its assets are held in liquid reserve-currency assets. The assets
of a currency board do not include domestic assets. 1 Because of this
limitation the currency board cannot hold government debt or act as a
‘lender of last resort’ which lends money to troubled commercial
banks.
Two factors that contributed to the Bulgarian financial crisis of
1996 −1997 were large government deficits and bad loans on commer-
cial bank balance sheets. An attraction of the currency board is that by
cutting off credit to both the government and commercial banks, the
currency board disciplines both institutions.
When Bulgaria adopted a currency board in July 1997, it chose the
Deutschemark as the reserve currency. This was somewhat controver-
sial because the dollar was widely used and oil imports, which are very
important, are priced in dollars. The Deutschemark had the advantage,
however, that it was soon to be merged with the Euro, and Bulgaria
hopes to join the European Union. With the adoption of the Euro in
January 1999, the Bulgarian lev is now fixed to the Euro.
1
In Argentina the reserve currency is the US dollar and the currency board does hold
some dollar-denominated government debt.

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 Discussion Papers
The currency board in Bulgaria has a structure similar to the cur-
rency board established earlier in Estonia where there is a separation
between the Issue Department and the Banking Department. In Bul-
garia there is also a third division, the Banking Supervision Depart-
ment. The Banking Supervision Department is the regulator of com-
mercial banks. The Banking Department has reserves that can be used
in a crisis situation to help banks. The heart of the currency board is the
Issue Department. The balance sheet of the Issue Department for 25
June 1999 is presented in Table 1. All foreign currency assets are en-
tered on the balance sheet of the Issue Department. Since the exchange
rate is fixed at BGL 1000/DEM, the total foreign assets of the currency
board were approximately DEM 5.1 billion (USD 2.7 billion).
An important difference between this balance sheet and the typical
currency board balance sheet is the presence of government deposits
and Banking Department deposits on the liability side of the account.
Theoretically, the only liability of a currency board would be the mon-
etary base. As Table 1 shows, government deposits and deposits of the
Banking Department together are actually greater than the monetary
base (M0).
The Banking Department provides a safety valve in the event of cri-
sis. The high inflation and sharp depreciation of the lev that occurred
during the financial crisis greatly reduced the value of the money sup-
ply. With more foreign currency reserves than were needed to provide
coverage for M0, reserves were set aside for the Banking Department.
Additional loans from the IMF have also made it possible to increase
the size of the Banking Department.
This structure has important advantages for a country that has an on-
going IMF program and large foreign debt service obligations. With a
currency board changes in foreign exchange reserves will affect the
size of the money supply. With this structure IMF tranches and pay-
ments of foreign debt obligations do not affect the monetary base. This
arrangement reduces the volatility of the money supply that would oth-
erwise be affected by large movements in the BNB’s holding of foreign
currency reserves.2
2
IMF tranches actually pass through the Banking Department and borrowings from
the IMF are a liability of the Banking Department. There is a four-week window after
the tranche is received where the government can make a decision to borrow this money

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This arrangement has some additional consequences, however.
First, because of these accounting features, the Bulgarian currency
board does not satisfy Williamson’s definition cited above. Changes in
the monetary base will not be equal to the country’s overall balance of
payments surplus or deficit when the government is engaged in interna-
tional transactions. International activities of the government are ‘spon-
taneously sterilized’ whether they are IMF tranches, foreign debt pay-
3
ments or receipts from privatization deals with foreign investors.
Second, government deficits will automatically be financed by
printing money. An increase in government spending will increase the
monetary base and have the same effect on the money supply as a deci-
sion by a central bank to buy government bonds when the government
deficit spends. For the same reasons, normal government receipts and
payments will affect the size of the monetary base and create additional
money supply volatility. To reduce this volatility, Nenovsky and Hristov
(1998) have argued that government deposits should be held at a com-
mercial bank instead of the currency board.
There are several trade-offs to be considered here. Government de-
posits were originally placed at the currency board because the banking
system was considered to be too weak (Enoch and Gulde, 1997). If de-
posits were placed at a commercial bank, IMF tranches and debt ser-
vice payments would create more money supply volatility than the
present arrangements. Another alternative would be for the government
to keep deposits at both the currency board and commercial banks. The
deposits at the currency board could be used for IMF tranches and debt
service, and the deposits at commercial banks could be used for normal
government operations. A possible disadvantage of this arrangement is
that the government could influence the size of the monetary base by
moving deposits from one account to another.

from the BNB. The government can then make payments from this account to service the
foreign debt. (A special exception was written into the law establishing the currency board
allowing the government to borrow these funds from the BNB.) (Enoch and Gulde, 1997)
Careful consideration is also given to how money from the World Bank affects the
money supply. Money which is passed to the government and eventually spent by the gov-
ernment will affect the money supply, but the World Bank is careful that the original trans-
fer of funds to the government does not significantly affect the monetary base.
3
Sterilization is usually associated with situations where central banks try to stop mon-
etary contractions when balance of payments deficits arise. The situation here is different
since there is no discretionary policy action being taken.

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 Discussion Papers
From the viewpoint of a purist, none of these arrangements is ideal.
Since the government’s deposits and its international transactions are
large, government activities will influence the size of the monetary
base. Under ideal conditions, money supply adjustments under a cur-
rency board system should reflect only imbalances in the balance of
payments.

II. Advantages of a Currency Board

Williamson (1995, p. 13) lists four advantages proponents claim for
currency boards:
“[a]that they assure convertibility; [b]that they instill macroeco-
nomic discipline; [c]that they provide a guaranteed payments ad-
justment mechanism; [d]that because of those three features they
create confidence in the monetary system and therefore promote
trade, investment and growth.

Convertibility
A key aspect of a currency board is its guarantee of currency con-
vertibility at a fixed exchange rate. To assure convertibility there must
be adequate reserves to cover any demands for foreign currency. Only
then is there a credible claim that citizens can always exchange the lo-
cal currency for reserve currency. A standard criteria for judging suffi-
cient coverage is that the currency board needs sufficient holdings of
the reserve currency to cover the monetary base (M0). For a currency
board where commercial banks hold their reserves at the currency
board, sufficient reserves to cover M0 will be adequate to guarantee the
fixed exchange rate but insufficient to prevent a banking crisis. Com-
mercial banks themselves will not have sufficient foreign currency to
guarantee the convertibility. People will be forced to withdraw money
from the banks and present their demands for foreign currency at the
currency board. The currency board will be able to honor these de-
mands, but the withdrawals will bring about a contraction of bank li-
abilities and the money supply as banks are forced to call in their loans
and sell other assets.
In Bulgaria gross foreign currency reserves far exceed the minimum
requirements for coverage of M0. As Table 1 illustrates, the Issue De-

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partment has foreign currency reserves of BGL 5.1 trillion and M0 is
only BGL 2.2 trillion. At the end of June foreign currency reserves at
the BNB were more than twice as large as M1. Indeed the ratio of broad
money to foreign currency reserves was only 1.21. These figures sug-
gest that the Bulgarian currency board should be able to honor its com-
mitments to the exchange rate fix.
While there should be no immediate problems, the longer-term pic-
ture is not so rosy. At the end of 1998 Bulgaria’s foreign debt was more
than USD 10 billion. (This was a 4% increase over the 1997 end-year
figure.) During 1998 debt service was almost USD 1.1 billion. Annual
service obligations for 1999 – 2001 are in the same range. To put these
figures in context, the government’s deposits in Table 1 represent a
little more than one year’s annual payments. The total assets of the Is-
sue Department are less than the debt service obligations over the next
three years.
The future strength of the currency board depends on the manage-
ment of these foreign debt service obligations. It is interesting to note
that while servicing more than USD 1 billion in foreign debt in 1998,
government balances at the BNB were almost the same in June 1999 as
they were in June 1998.
In 1998 the foreign debt was managed largely by borrowing addi-
tional funds from official creditors, mainly the international financial
institutions (IFIs), i.e. the IMF, World Bank, European Union, etc.
While almost USD 500 million of the USD 1.1 billion in service obliga-
tions were payments to IFIs, Bulgaria’s total indebtedness to IFIs in-
creased by more than USD 300 million. Bulgaria is becoming more de-
pendent on the IFIs to finance its foreign debt obligations.
Promises from the IFIs for 1999 fall far well below debt service ob-
ligations. IMF and World Bank loans are expected to total about
USD 500 million and there are perhaps another USD 100 million from
other sources. Recently there have been negotiations for additional
loans.
Other potential sources of foreign currency reserves include foreign
direct investment, portfolio investment and floating a Eurobond. At-
tracting private portfolio money or floating a Eurobond has been made
more difficult by the financial crises in emerging markets, especially
the crisis in Russia. The war in Kosovo has further highlighted prob-

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Discussion Papers
lems in the region. Efforts to attract foreign direct investment have fo-
cussed on privatization efforts. In 1997 foreign direct investment was
USD 636 million, but the pace has slowed in 1998 to USD 436 million.
The much anticipated sale of the Bulgarian Telecommunications Com-
pany (BTC) still has not been concluded (OECD, 1999). While the sale
of BTC should bring in a substantial sum, many state-owned enter-
prises have deteriorated during the past decade, and their sale is un-
likely to bring sufficient foreign currency flows to have a substantial
impact on the underlying foreign debt problems.
Current account surpluses are another potential source of foreign
currency reserves. We discuss these issues in more detail in Section III.
Suffice it to say here that while the current account was in surplus in
1997, Bulgaria’s current account fell into deficit in 1998 and the dam-
age to roads and bridges in Yugoslavia during the war in Kosovo is
making trade more difficult.
The high inflation that preceded the establishment of the currency
board in Bulgaria created a situation where there were more than
enough foreign exchange reserves to provide immediate cover for M0,
but without the support of IFIs, the foreign debt problem could still
threaten the viability of the board. Because of these debt problems, de-
pendence on the IFIs has grown over the past two years. It is still too
early to determine whether the stability provided by the currency board
will provide sufficient impetus to the private sector to reverse this
trend, but it is unlikely that these changes will occur quickly.

Macroeconomic Discipline
Advocates of currency boards argue that they will instill macroeco-
nomic discipline. Williamson views fiscal policy, in particular, as a po-
litical problem that may or may not be solved by the establishment of a
currency board.
Very weak commercial bank balance sheets and large government
deficits helped bring on the Bulgarian financial crisis in 1996 – 1997.
Proponents of the currency board hoped that the establishment of the
currency board would signal a change of regime and greater economic
discipline.
4
While the war in Kosovo has made it more difficult to attract private capital flows, it has
strengthened Bulgaria’s position in its negotiations to obtain additional funds from the IFIs.

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During the period leading up to the crisis the BNB provided com-
mercial banks with refinancing. The banks then loaned the money to
enterprises. These loans were a form of implicit subsidy since there was
little chance they would be repaid. “Until 1996, commercial credit was
expanded to the nonfinancial sector in Bulgaria to a degree that was un-
precedented relative to any other European transition economy.”
(OECD, 1999, p. 32).
Government attempts to recapitalize the banks failed. The govern-
ment replaced bad loans to enterprises with government bonds. Banks
then made additional loans, and their balance sheets did not improve.
The government bonds increased the level of government debt and the
interest obligations on this debt ballooned creating large government
deficits. By 1996 interest payments were 17% of GDP.
The currency board has effectively brought an end to these prob-
lems. Since the Bulgarian currency board cannot hold domestic debt, it
cannot refinance the banks nor can it hold government debt. The high
inflation during the crisis reduced the value of the lev-denominated
government debt from 70% of GDP in 1996 to less than 15% of GDP at
the end of 1998. Interest rates also fell dramatically greatly reducing the
servicing burden (OECD, 1999). The fiscal budget was in surplus in
1998. For 1999 the government projects a deficit of 2.8%, but the
money is to be used to upgrade a badly deteriorating infrastructure.
The situation in the banking sector has also improved dramatically.
The banks have reduced their exposure to the nonfinancial sector and
the capitalization of the banks rose to 36.7% in 1998 (against the mini-
mum requirement of 10%) (OECD, 1999). Initially the banks did little
additional lending to the nonenterprise sector and expanded their cash
holdings and their holdings of government bonds. As Table 2 illus-
trates, more recently banks have taken less conservative positions and
have expanded the amount of lending to the nonfinancial sector and re-
duced their cash holdings.
After many years of struggling with inflation, inflation has also
come down dramatically with the establishment of the currency board.
At the end of the financial crisis in February 1997, monthly inflation
was 240%. End-period CPI inflation for the year 1998 was 1.0% on an
annual basis.

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 Discussion Papers
The experience with output growth has been positive but less spec-
tacular. Output grew in 1998 by 3.5% after declining by 6.9% in 1997.
This improvement is less impressive than it first appears. The financial
crisis ended in the first quarter of 1997 and output was very low. GDP
recovered some by the third quarter, but output has not grown since
5
then (OECD, 1999).
Evaluating the overall macroeconomic experience in Bulgaria dur-
ing the first two years, the currency board has to be given high marks.
The currency board was instituted at a time when people had little faith
in macroeconomic policymakers and the economy was in a shambles.
Inflation has come down to reasonable levels, the government’s budget
has been balanced, and the banks are taking greater care of their assets.
These are certainly major accomplishments. While the economy has not
really started to grow, the economy has been stabilized, and it is easier
for economic decision makers to make new business plans with longer
horizons.

Guaranteed Adjustment Mechanism

Under a currency board arrangement balance of payments (BOP)
equilibrium is maintained through an automatic adjustment mechanism.
As with the gold standard BOP deficits create outflows of foreign ex-
change reserves and a reduction of the money supply. The fall in the
money supply forces interest rates upward and a contraction in the
economy. This contraction will result in lower output and prices. The
fall in output should be smaller if the fall in prices is greater. Higher in-
terest rates create capital inflows. The fall in output depresses import
demand and the fall in prices increases the competitiveness of exports.
All three changes help restore BOP equilibrium. When there are BOP
surpluses, the opposite forces act to restore equilibrium.
The long-term sustainability of the currency board depends on this
mechanism. The automatic nature of the adjustment relies on a close re-
lationship between foreign exchange reserves and the money supply.
The Bulgarian currency board is designed to reduce the impact on the
money supply when there are financial flows from the IMF and major
debt service payments are made. This structure has the advantage of re-
5
The IMF’s immediate post-Kosovo war projection for GDP growth in 1999 is 1.5%.

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dp/11/1999
ducing the volatility of M0 which would be caused by these flows, but
it also means there is no longer a direct connection between BOP dis-
equilibria and adjustments in the money supply. For example, if the
BOP were in deficit, large government expenditures could be used to
offset what otherwise would be a decline in M0. This would stop the
contraction needed to restore BOP equilibrium.
Thus the design of the Bulgarian currency board has important ad-
vantages, but it also creates the danger that the additional flexibility be-
tween foreign exchange reserves and money supply will hinder the op-
eration of the automatic adjustment mechanism which otherwise should
ensure BOP equilibrium. In the long run this could affect confidence in
the sustainability of the currency board.

Confidence in the Monetary System and Promotion of

Trade, Investment and Growth
In Williamson’s list of advantages for currency boards, the last point
is that a currency board should create confidence and promote trade and
growth. A recent empirical study by Ghosh, Gulde and Wolf (1998)
finds that economies that adopt currency boards do have better inflation
experiences, and this improved inflationary environment does promote
better growth.
When the currency board was adopted in July 1997, there were im-
mediate indicators of confidence in the exchange rate fix. As illustrated
in Figure 1, interest rates fell dramatically as the establishment of the
currency board was anticipated. Interest rates reached single-digit an-
nualized levels once the board was in place.
These changes are to be expected since speculators will arbitrage
between the Deutschemark and Bulgarian lev. The interest rate pre-
mium on lev securities is a measure of the additional risk in the Bulgar-
ian market. The interest rate differential between the Deutschemark
three-month LIBOR and the three-month Bulgarian government bond
has been around 2% since the beginning of 1998.
This dramatic fall in nominal interest rates had two important ef-
fects. First, lower interest rates greatly reduced the government’s do-
mestic debt service obligations and helped the government gain control
of its budget. Secondly, the fall in nominal interest rates occurred be-

14
 Discussion Papers
fore inflation came down. At first real interest rates were negative, al-
though they have recovered as inflation has also come down.
While the currency board has been able to stabilize the exchange
rate, it has not brought a significant inflow of foreign capital. A number
of privatization deals were completed in 1997. Foreign direct invest-
ment climbed, but the crisis in emerging markets and a slowdown in
privatization reduced the level of foreign investment in 1998. Per
capita foreign investment is much lower than most other Eastern Euro-
pean countries and even in 1997 it was still only USD 60 (OECD,
1999).

III. Disadvantages of a Currency Board

Williamson lists a number of disadvantages of a currency board. In
this section we discuss only those problems which are most relevant to
the Bulgarian case. These are: (a) the transition problem which arises
when inflation leads to overvaluation of the real exchange rate; (b) the
adjustment problem caused by BOP disequilibrium; (c) the crisis prob-
lem in the banking system because there is no lender of last resort; and
6
(d) the political problem.

Transition Problem
The transition problem is the problem of bringing inflation down
quickly enough after the establishment of the currency board. Fixing
the exchange rate should bring inflation down, but inflation can have a
momentum that leads to an overvaluation of the real exchange rate. The
gold standard mechanism will eventually correct the BOP imbalance
that results, but the adjustment can be long and painful.
In Bulgaria there was some inflationary momentum, but it was
short-lived. Following the very high inflation during the first half of the
year, the CPI rose only 16% during the second half of 1997 and only
6
The other issues that Williamson discusses are: seigniorage, the start-up problem and
the management problem. Currency boards allow countries to collect seigniorage where
simply using another reserve country’s currency does not. The start-up problem is the
problem of collecting sufficient foreign currency reserves before establishing the currency
board. The management problem is the inability of a country with a currency board to
manage its monetary policy. This last problem is discussed below when the adjustment
problem is analyzed.

15
dp/11/1999
1% in the 1998. During the first four months of 1999, the price level
actually fell a little.
To determine whether this inflation would cause an overvaluation of
the lev depends on where the nominal exchange rate fix was initially
set. Figure 2 plots the real exchange rate (lev/US dollar) deflated by the
PPI for the period beginning in January 1990. As can be seen in the
graph, the real exchange rate fluctuated dramatically during the period
immediately preceding the establishment of the currency board. This
made it more difficult to determine an appropriate nominal rate. The
nominal exchange rate chosen secured a real rate in the middle of the
range during the 1990s. Since the currency board system was imple-
mented, the lev has actually depreciated against the dollar in real terms
because of the appreciation of the dollar against the Deutschemark.
While the real exchange rate has not appreciated against the dollar,
the balance on the current account has moved from surplus to deficit.
So a transition problem has arisen. The current account surplus in 1997
was USD 426 million and the current account deficit in 1998 was USD
272 million. Preliminary figures for the first four months of 1999 show
a continuing current account deficit of USD 320 million. The impact of
the war in Kosovo is not reflected in these figures.
Most of this shift is occurring in the trade balance. As Table 3 illus-
trates, most of the change in the trade balance between 1997 and 1998
is due to a fall in exports. A comparison of first quarter statistics shows
that the improvement in the economy since the first quarter of 1997 has
led to an increase in imports, but the major overall factor leading to the
deficit is the decrease in exports. Falling exports to the former Soviet
Union (USD 338 million) account for more than half the decline. Ex-
ports to Turkey also fell by USD 100 million (22%). On the other hand,
exports to the European Union, which now constitute one-half of all ex-
ports, were almost unchanged between 1997 and 1998. This suggests
that the real appreciation of the lev against the Deutschemark did not
have an immediate impact on exports to that region.
According to preliminary figures overall exports declined another
24% in 1999, first quarter 1998 to first quarter 1999 (see Table 3). Ex-
ports to the European Union fell 9%, and there were further declines in
exports to the former Soviet Union. Exports to the former Soviet Union
in 1999 were only one-third the level of the comparable period in 1997.

16
 Discussion Papers
Thus, Bulgaria has a current account deficit problem as it transitions
to a currency board, but continuing inflation did not play a central role.
The BOP problems have different causes. Bulgaria has been hurt by the
crisis in emerging markets, particularly the crisis in Russia and its af-
fects on other countries in the region. However, between 1997 and 1998
the real problem was that Bulgaria was unable to expand its export
trade in any other major region.

Adjustment Problem
Unlike other countries that have had a currency board for a longer
period of time, the currency board in Bulgaria has not really been
tested. This may soon change with the growing current account deficits.
While there was no speculation against the lev when the Russian crisis
occurred, continuing current account deficits could cause a contraction
in the economy. Williamson refers to this as the adjustment problem.
The adjustment process unfolds when BOP deficits lead to a con-
traction in the monetary base, a fall in the money supply and a decline
in aggregate demand. Either a fall in output or a decline in prices can
improve the current account balance. The greater the decline in prices,
the smaller the decline in output needed to bring about equilibrium.
Figure 3 plots the movement of the monetary base over the period of
the currency board. It is clear from a comparison of Table 3 and the
changes in Figure 3 that there are more factors affecting the monetary
base than the changes in the current account. The dramatic increase in
the monetary base in late 1997 when the currency board was first estab-
lished reflects a portfolio readjustment following the hyperinflationary
period that preceded it. Holding levs was a much safer bet than before.
This created an inflow of foreign currency reserves.
Figure 3 also shows an increase in M0 during 1998 in spite of cur-
rent account deficits. The first six months of 1999 show a sharp decline
in M0 in January and then a slight decline after that. Because of the
large swing in M0 in December (for both 1997 and 1998), it may be
more useful to compare November 1998 and June 1999. Over this pe-
riod M0 declined by BGL 54 billion (DEM 54 million) or 2.5%. Be-
cause there was a small increase in the money multiplier over this pe-
riod the money supply actually increased by BGL 81 billion (DEM 81
million) or 1.3%. While current account figures are available only

17
dp/11/1999
through April 1999, the current account deficit from November to April
was USD 385 million.
From these figures it does not appear that the current account deficit
is creating a monetary contraction. On the other hand, the decline in ex-
ports is reducing aggregate demand. This should slow the growth of the
economy. If the money supply contracted, this would reduce aggregate
demand even more.
Under a currency board arrangement there is little that can be done
to offset these contractionary pressures. In a more flexible environment
expansionary fiscal or monetary policy might slow the contraction. If
Bulgaria had a floating exchange rate, a depreciation of the real ex-
change rate might spur exports. None of these options exist under a cur-
rency board.
The impact of contractionary policies on prices can be very impor-
tant. If prices are more flexible in a downward direction, the contraction
in output should be less severe. Figure 4 shows the relationship between
monthly CPI adjustments in Germany and Bulgaria. The increase in the
CPI during the first six months of the currency board was higher in Bul-
garia, but in 1998 the CPI increases were almost the same: 0.6% in Ger-
many and 1.0% in Bulgaria. The volatility of price adjustments in Bul-
garia was much greater. In several months Bulgarian prices fell, in part
because food prices fell almost 5% in 1998. This suggests that Bulgar-
ian prices might indeed fall more during a contraction than a country
like Germany. This should ease the output effects of a contraction
caused by the adjustment process that will take place under a currency
board arrangement.
Current account deficits and BOP deficits are not equivalent. The
current account deficit can be offset by increases in foreign investment.
This is an alternative mechanism under which a currency board ar-
rangement relies on growth in the economy to correct the current ac-
count imbalance. Under this scenario, foreign investment will lead to
greater growth and an eventual reduction in the current account deficit.
With this adjustment mechanism, which appears to be the pattern that is
unfolding in Bulgaria, the viability of the currency board depends on
the efficient use of foreign investment to increase productivity. It is too
early to determine whether these productivity improvements are occur-
ring in Bulgaria.

18
 Discussion Papers
Crisis Problem
What Williamson refers to as the crisis problem arises because there
is no ‘lender of last resort’ under a formal currency board. In Bulgaria
there is more flexibility. When the currency board was established, a
Banking Department was created to provide protection during a crisis.
A substantial amount of money was put aside in the Banking Depart-
ment and has increased since the board was created. In June 1999 the
deposits of the Banking Department at the Issue Department were
140% of bank reserves (Table 1).
Offsetting this advantage is the small presence of foreign banks in
Bulgaria. Most countries with currency boards have been countries
where foreign banks were dominant, as with the British colonies. Hong
Kong and Argentina are exceptions, but the presence of foreign banks
in these countries is also greater than in Bulgaria. Argentina experi-
enced a run on its banks in 1994 – 1995 during the Mexican debt crisis.
The exchange rate was maintained, but reserve requirements were re-
duced by half – a very noncurrency board thing to do. The IMF pro-
vided large loans, and small banks were absorbed by large banks
(Williamson, 1995). Since then Argentina has organized large lines of
credit which can be called upon in the event of another crisis.
If banks have lines of credit in foreign currency upon which to draw,
the contraction will be less severe. Foreign banks should be able to
draw on their parent banking institutions for resources in the reserve
currency, especially if their parent is in the reserve currency country.
For Bulgaria today any bank from Euroland would serve this function.
At present, foreign banks make up only a small portion of the commer-
cial banking sector. This could change significantly if Bulbank, for-
merly the Foreign Trade Bank, is purchased by a foreign bank. Bulbank
has approximately one-third of commercial banking assets in Bulgaria.
It is difficult to judge what will happen during a financial crisis, but
one can interpret from portfolio behavior what economic agents per-
ceive the risks to be. Under a currency board the risk of currency de-
valuation is reduced, but the risk of bank failure is greater. In Figure 5
the cash-to-deposit ratio is plotted for period beginning in December
1990.7 As can be seen from the figure, the cash-to-deposit ratio rose
7
Deposits include both lev and foreign currency deposits.

19
dp/11/1999
dramatically when the currency board was established. This rise re-
flects the greater confidence in the lev as people exchanged dollars for
lev. But confidence in the banks is still weak.
The behavior of banks has also been conservative since the estab-
lishment of the currency board. Figure 6 shows the ratio of bank depos-
its to reserves. During the currency board period the required reserve
ratio (also shown on the graph) was 11%. Until very recently banks
have been holding reserves well above this level. As seen in Table 2,
recently banks have become more aggressive and have reduced their
cash holdings and extended more loans. In part this reflects changes in
the procedures for determining compliance with the minimum reserve
requirements, but it may also reflect pressures on bank profitability. It is
difficult for banks to make profits if they are holding large cash bal-
ances and low interest paying government securities.

Political Problem
The last disadvantage that Williamson lists is the political problem.
The question he raises is whether the currency board will really impose
controls on the fiscal authority. He remains skeptical that this will nec-
essarily be the case.
Thus far the currency board in Bulgaria has created an environment
where the government has been able to control budget deficits. If there
is a political problem, it is the appearance, perhaps, that the currency
board is too strong. In political debate the government has used the cur-
rency board to deflect demands on the budget. This has created an envi-
ronment where the greatest political threat to the currency board is not
the fiscal actions of the present government, but the political attacks on
the currency board.

IV. Conclusions
There are many challenges in the Balkans. After climbing one
mountain, there is another mountain in your path. The Bulgarian
economy has climbed a high mountain, but there are many challenges
ahead. The currency board has brought needed discipline to the
economy. The money supply is no longer growing too rapidly. Govern-
ment budgets are now under control. Banks’ lending is much more cau-

20
 Discussion Papers
tious. The result is that inflation has come down dramatically, and the
economy is beginning to grow.
Having met these challenges, there are others that still lie ahead.
Bulgaria still has a very large foreign debt. The servicing of the debt is
still a problem, and there is a heavy reliance on the IFIs to provide sup-
port for these payments. These problems have been made more difficult
because the current account is now in deficit.
The current account deficit may well create serious challenges for
the currency board. This deficit has arisen in large measure because of
factors outside Bulgaria. Still declining exports are contractionary, and
the currency board arrangement provides no mechanism for offsetting
these forces. At the same time, Bulgaria is being spared an even more
painful experience since the contraction is smaller than it would have
been if the money supply had not continued to expand. Even if the
money supply does not fall, a decline in output at this stage could create
additional political problems
The longer-term solution to these problems, however, is growth. It is
still too early to determine whether the increased stability brought on
by the currency board and the inflow of new foreign capital will be suf-
ficient to increase productivity. If productivity improves, Bulgarian
goods will become more competitive and the current account will read-
just. If productivity does not improve, then the long-term viability of
the board will be in question.
The currency board in Bulgaria is beginning to mature as economic
agents are gaining a better understanding of the constraints they now
face. The government has more confidence now and has been contem-
plating a small deficit to improve infrastructure. Banks are beginning to
lend more as they reduce their holdings of cash and government securi-
ties. The question now is whether the government and the banks can
now proceed prudently when the constraints appear to be less severe.
The currency board has brought stability to the economy. The next
stage will test whether these gains can be consolidated and longer-term
growth can be achieved.

21
dp/11/1999
Table 1

WEEKLY BALANCE SHEET OF ISSUE DEPARTMENT

AS OF 25 JUNE 1999
(million BGL)
ASSETS LIABILITIES

Cash and nostro accounts

in foreign currency 1 174 463 Currency in circulation 1 623 821

Monetary gold 627 509 Bank deposits and

current accounts 552 655
Foreign securities 3 291 183 Government deposits
and accounts 2 196 484
Accrued interest receivable 57 241 Other depositors’ accounts 367
Accrued interest payable 414
Banking Department deposit 776 655

ASSETS 5 150 396 LIABILITIES 5 150 396

Source: BNB.

Table 2
AGGREGATE BANK BALANCE SHEETS
(Percentages of major liability categories)
(%)
1996 1997 1998 1999
Dec. Dec. June Dec. Feb.

Cash 10 19 16 14 12
Government securities 24 24 25 20 21
Claims on banks and other financial institutions 24 29 28 32 30
Claims on nonfinancial institutions 39 22 23 27 29

Source: BNB

22
 Discussion Papers
Figure 1
ANNUAL COMPOUND BASE INTEREST RATE
90

80

70

60

50

40

30

20

10

0
1997:V VI VII VIII IX X XI XII 1998:I II III IV V VI VII VIII IX X XI XII 1999:I II III

Source: BNB.
Figure 2
REAL EXCHANGE RATE (PPI)
(USD)
40

35

30

25

20

15

10

0
1991 1992 1993 1994 1995 1996 1997 1998 Jan.
1999

Source: BNB.

23
dp/11/1999
Table 3
BALANCE OF TRADE 1997 − 1998
(million USD)
Q1 Q2 Q3 Q4 Total

1997
Trade balance 308.8 46.5 97.7 -72.6 380.4
Exports, fob 1190.9 1233.5 1272.0 1243.3 4939.7
Imports, fob 882.1 1187.0 1174.2 1315.9 4559.3

1998
Trade balance 1.6 -68.9 -104.3 -157.9 -329.5
Exports, fob 1103.4 1113.0 1027.3 1050.2 4294.0
Imports, fob 1101.8 1181.9 1131.6 1208.2 4623.5

1999
Trade balance -165.7
Exports, fob 865.8
Imports, fob 1031.5

Change between 1997 & 1998

Trade balance -307.2 -115.4 -201.0 -85.3 -709.9
Exports, fob -87.5 -120.5 -244.7 -193.1 -645.7
Imports, fob 219.7 -5.1 -42.6 -107.7 64.2

Source: BNB.

24
 Discussion Papers
Figure 3
MONETARY BASE
(billion BGL)
3000.000

2500.000

2000.000

1500.000

1000.000

500.000

0.000
5'97 6'97 7'97 8'97 9'97 10'97 11'97 12'97 1'98 2'98 3'98 4'98 5'98 6'98 7'98 8'98 9'98 10'98 11'98 12'98 1'99 2'99 3'99 4'99 5'99 6'99

Source: BNB.

Figure 4
MONTHLY CPI CHANGES IN BULGARIA AND GERMANY
6

-1

-2

-3
1997 1997 1997 1997 1997 1997 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998

Bulgarian CPI German CPI

Sources: BNB, IMF: International Financial Statistics.

25
dp/11/1999
Figure 5
CASH/DEPOSIT RATIO
0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00
12'90 06'91 12'91 06'92 12'92 06'93 12'93 06'94 12'94 06'95 12'95 06'96 12'96 06'97 12'97 06'98 12'98 06'99

Source: BNB.

Figure 6
BANK RESERVE/DEPOSIT RATIO
0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
12'90 06'91 12'91 06'92 12'92 06'93 12'93 06'94 12'94 06'95 12'95 06'96 12'96 06'97 12'97 06'98 12'98 06'99

Bank Reserve/Deposit Ratio Reserve Requirement Ratio

Source: BNB.

26
 Discussion Papers
Bibliography
Enoch, C. and Anne-Marie Gulde (1997) Making a Currency Board Operational. IMF
Paper on Policy Analysis and Assessment, Monetary and Exchange Affairs
Department, International Monetary Fund.
Ghosh, A., Anne-Marie Gulde, and Holger C. Wolf (1998) Currency Boards: The Ul-
timate Fix? Policy Development and Review Department, Monetary and Ex-
change Affairs Department, International Monetary Fund, WP/98/8, January
1998.
Nenovsky, N. and Kalin Hristov (1998) Financial Repression and Credit Rationing
under Currency Board Arrangement for Bulgaria. Bulgarian National Bank
Discussion Papers, DP/2/1998.
Organization for Economic Cooperation and Development (1999) Economic Sur-
vey of Bulgaria, OECD, Paris.
Williamson, J. (1995) What Role for Currency Boards? Institute for International Eco-
nomics, Washington, D.C.

27
dp/11/1999

DISCUSSION PAPERS
NOW AVAILABLE:

DP/1/1998 The First Year of the Currency Board in Bulgaria

Victor Yotzov, Nikolay Nenovsky, Kalin Hristov, Iva Petrova, Boris Petrov
DP/2/1998 Financial Repression and Credit Rationing
under Currency Board Arrangement for Bulgaria
Nikolay Nenovsky, Kalin Hristov
DP/3/1999 Investment Incentives in Bulgaria: Assessment
of the Net Tax Effect on the State Budget
Dobrislav Dobrev, Boyko Tzenov, Peter Dobrev, John Ayerst
DP/4/1999 Two Approaches to Fixed Exchange Rate Crises
Nikolay Nenovsky, Kalin Hristov, Boris Petrov
DP/5/1999 Monetary Sector Modeling in Bulgaria, 1913 – 1945
Nikolay Nenovsky, Boris Petrov
DP/6/1999 The Role of a Currency Board in Financial Crises:
The Case of Bulgaria
Roumen Avramov
DP/7/1999 The Bulgarian Financial Crisis of 1996 – 1997
Zdravko Balyozov
DP/8/1999 The Economic Philosophy of Friedrich Hayek
(The Centenary of his Birth)
Nikolay Nenovsky
DP/9/1999 The Currency Board in Bulgaria: Design, Peculiarities
and Management of Foreign Exchange Cover
Dobrislav Dobrev

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